Real Estate Investing for Multi-Generational Families
Real estate is a unique asset class. Residential real estate values have grown 4.3% on average each year since the beginning of the Case-Shiller National Home Price Index in 1987. According to data from the St. Louis Fed, commercial real estate appreciates between 3% and 4% annually as well. That may sound like low returns, but real estate is generally bought with leverage in the form of a mortgage, which increases annual returns into the mid-teens depending on the amount of debt used in the transaction. In addition to returns, direct real estate investing may offer tax advantages. Interest and depreciation may be tax deductible. For multi-generational families, strategies like 1031 exchanges can defer capital gains taxes as the current owners sell existing assets and buy new properties. Eventually, the portfolio can be passed to the next generation without paying capital gains taxes. All of this compares favorably to the stock market, with less volatility.
Large institutional investors, like pension funds and endowments, have long allocated significant assets to real estate. Despite the return profile, many multi-generational families do not own real estate beyond properties they use personally. The same is true for smaller endowments and foundations. Given the opportunities, we believe real estate should be a part of a portfolio designed to span many generations.
As you consider real estate holdings, be sure to read our real estate market update article nearby. Plus, listen to the podcast to hear our discussion on multi-generational real estate investing.
How Much Real Estate Should I Own?
Consider real estate in the context of your total portfolio. According to Blackrock, endowment real estate exposure averages around 11%, with some funds holding materially higher amounts of real estate. NAREIT’s analysis shows that pensions and endowments allocate about 14% to real estate. We think 10%-20% is a good guide. When you combine your personal homes with your investment assets, does the real estate portion total more than 20% of your assets? If so, you may have enough exposure to real estate. If not, there may be an opportunity to allocate more assets to real estate depending on your risk tolerance and situation.
How to Start Building Multi-Generational Real Estate Portfolio
The best way to gain exposure to pure real estate is to buy properties directly. REITS are publicly traded real estate funds. However, REITS tend to trade in-line with the stock market, not with underlying real estate prices. Because REIT returns are historically lower than the S&P 500 and the two assets tend to move in the same direction, REITs provide little benefit to an investment portfolio that would otherwise be invested in stocks. We suggest private real estate funds and investing directly into properties.
Private real estate funds are a good alternative to public REITS while you start building a portfolio, especially while rates are high. They can be opportunistic and invest as properties come up for refinancing. However, many private real estate funds will not provide the tax benefits that come with direct ownership. Even if you start with a private fund, your goal should be to invest directly into properties over time as rates normalize.
Here are a few steps to get started buying individual properties:
1) Start small! Long and short-term residential rentals are a great place to start. The property does not need to be a luxury space. It just needs to be a place that is in demand at rental rates that cover the mortgage plus expenses.
2) Consider using debt. Downpayments for residential rental are typically 20%-25%. Using debt will magnify your returns over time.
3) Find a guide. We help clients review potential real estate transactions, but there is no substitute for a local agent that specializes in rental properties in your area.
4) Make a property management plan. You may choose to hire a property manager to cover maintenance and marketing, or “do it yourself.” If you choose to manage your property, make sure you understand how to price and market the space to achieve your rent goals. Also, think about who will be solving problems at 3am when the HVAC unit stops working.
5) Property management is a great opportunity to engage younger members of your family in your business activities!
6) Remember to save for maintenance expenses. We recommend setting aside $500 to $1,000 a month to pay for property expenses as they arise (or more for more expensive properties).
Scaling and Diversifying Generational Real Estate Portfolios
As your portfolio grows over time, remember to diversify to mitigate location and property type risk. Many investors start buying properties near their home because they know the market. Over time, consider buying in a neighboring city. Real estate markets are very location dependent, and one location may fall out of favor before you are able to sell your holdings. Also diversify across property types. If you start with residential rentals in your city, consider a smaller commercial property like self-storage in a nearby city. Diversification is important, but don’t spread your investments out so much that you are not able to build market knowledge. We suggest sticking with a few locations and one or two property types in each location as you expand your portfolio. You receive the benefits of both diversification and scale over time.
Transferring Properties to Next Generation
Real estate is a great multi-generational investment. If you buy the right assets, those assets can be held for decades. Additionally, there is a program known as a 1031 exchange that you may utilize to sell one property and purchase another while delaying the payment of capital gains taxes. The combination of 1031 exchanges and effective estate planning will allow you to transfer properties to your children and limit the capital gains taxes paid. Like many wealth transfer strategies, fully realizing the benefits of this strategy requires careful planning over many years, so start early!
Sources:
https://www.reit.com/news/blog/nareit-developments/role-real-estate-pension-funds
https://www.blackrock.com/institutions/en-us/insights/investment-actions/portfolio-construction-endowments